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It in this post, I’ll put in a table, the types of depreciation methods that are acceptable to the IRS in calculating depreciation. Depreciation is the reduction in the value of something you purchase and keep for use. For example, if you purchase a car for $25,000, normally you can’t deduct the whole cost of the car in one year (because you use it for many years). You can instead deduct ‘depreciation’ i.e. a portion of the cost of the car over a number of years.
What are the types of depreciation methods and their formulas?
In the below, I’ll list out the types of depreciation methods that are acceptable to the IRS.
[INSERT TABLE]
| Depreciation method | Formula to calculate annual depreciation | Effect | What it’s generally used for | Examples |
|---|---|---|---|---|
| Straight-line depreciation | Basis – Salvage Value) ÷ Useful life | Same amount each year | Immovable property like land and buildings | Apartment building / Office building |
| 150% declining balance | Adjusted basis* x (1.5 ÷ Useful life) *Adjusted basis is the new basis each year after adjusting for depreciation | A different amount each year, each amount the year after is less than the previous year. | 15 and 20-year MACRS recovery period property What’s MACRS? Check out this post. | Billboards / Natural gas distribution lines |
| 200% declining balance | Adjusted basis* x (2 ÷ Useful life) | Similar to 150% declining balance however, the amount of the depreciation is always more than 150%. | 3, 5, 7and 10-year MACRS recovery period property. | Office furniture and equipment, automobiles, computers. |
| Unit-of-production method | (Basis – salvage value) x (number of units produced during the tax year / estimated total of units asset will produce) | The more that’s produced in a tax year, the greater the depreciation. | Exclude under MACRS and elect to depreciate property under this method. | Usually used for equipment in exploiting natural resources (mines, wells etc…) and space above landfill or dumps. |
| Operating days method (to calculate machine-hours, just replace “days” with “hours”) | (Basis – salvage value) x (number of days used in the year / total number of days that the item can be used) | The more days the asset is operated, the greater the depreciation. | Exclude under MACRS and elect to depreciate property under this method. | A retail butcher in a market could use this for a meat-slicing machine. Because the butcher only opens weekends and closes on Sunday and Monday, they could use the operating days method. |
| Income forecast method | (Basis – Salvage Value) x (Income generated from property during tax year / Estimated total of income from the property during its useful life) | Depreciation appears to ‘match’ in proportion to the amount of income that’s produced. The more income, the greater the depreciation. | Film, video tapes, sound recordings, copyrights, books and patents must use this method and not MACRS. | Films make money from movies screening so it would make sense that depreciation should ‘match’ income for the year rather than being a set amount like in straight line. |
Why are there so many depreciation methods?
There are many reasons why there are so many depreciation methods.
However, it comes down to the fact that there are different types of property and because of this, one method of depreciation may suit a certain type of property but not another. If it doesn’t suit that other property, it may disadvantage the company or provide an unfair benefit.
For example, the depreciation method that would be appropriate for a computer (that’s thrown away quickly / gets outdated quickly and is easily replaceable) wouldn’t be the same for something like a sewer (which should be built to last) or a billboard.
Another example is with machinery that produces nic-nacs. One year the machine may produce 100,000 nic nacs and the next year, due to an increase in demand, the machine may produce 500,000 nic nacs. Because the machine deteriorates based on the number of units produced, it seems more appropriate to use the units-of-production method. In such cases, the declining balance method wouldn’t ‘match’ income and straight-line assumes the same depreciation each year even though the machine is used more in the second year.
Hope you found this post useful and please comment below…
Next: MACRS Depreciation Table (US IRS taxation)